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06/24/2007

Subprime Mortgage Loans--Posner's Comment

The subprime-mortgage imbroglio is just the latest chapter in an age-old concern with the charging of interest, especially to individuals. Medieval Christianity forbade the charging of interest on the ground that it was unnatural for money to increase (as by lending $100 at a 10 percent interest rate so that at the end of the year the $100 has grown to $110), because unlike pregnancy there was no mechanism by which an inanimate object such as money could reproduce itself. Behind this superstition lay undoubtedly a hostility to commercial society, which persists today in some quarters of the Muslim world; Islam forbids charging interest although substitutes are tolerated. The concern with lending has persisted into modernity even in Western societies. Usury laws, which set a ceiling on interest rates, and the Truth in Lending Act, which requires detailed disclosure of annualized interest rates in consumer loans, are examples of this concern.
The relaxation of usury laws--a natural concomitant of the spread of free-market ideas in American society--allowed lenders to offer loans at very high interest rates to borrowers with poor credit ratings. Payday loans, which charge astronomical interest rates to persons who need money to tide them over till their next paycheck, and subprime mortgage loans sometimes at annual rates 4 or 5 percent higher than mortgage loans to borrowers who have good credit, were consequence of the relaxation.
I agree with Becker that credit is no different from any other commodity. For government to place a ceiling on price prevents people from buying the commodity who would be willing to pay a higher price, and thus it prevents a mutually beneficial, and therefore value-maximizing, transaction. The argument for the ceiling is that people who have a poor credit record have demonstrated their incompetence to borrow and so should for their own good be prevented from borrowing more. That is not a compelling argument, apart from any general objections to government paternalism than one may have. A person may have a poor credit record, yet know that he can pay a high interest rate and that he will be better off despite the cost. As Becker notes, although the rate of default on subprime mortgage loans is high, still, the vast majority of those loans are repaid. For many people they are the only route to home ownership, which is greatly valued by the owners but has also been thought (perhaps dubiously) to have social value; that at any rate is the rationale for the tax deductibility of mortgage interest.
I do think that there is reason to think that the subprime mortgage market is imperfect, though not reason enough to warrant government interference with that market. The subprime mortgage lenders have engaged in aggressive marketing that may have deflected borrowers from shopping for better terms in the prime market. There are of course many gullible consumers and many people who have difficulty understanding the cumulative costs of high interest. There are also many people who like to speculate or otherwise gamble without a good appreciation of the odds. Perhaps there is even something of a "bubble" aspect to the subprime market. When housing prices were rising, borrowing to buy a house even at a high interest rate (interest rates generally were low until very recently, but high to subprime borrowers) was a leveraged investment, both on the borrowing side and on the lending side. The borrowers expected to repay the high interest out of the rapid appreciation in the value of the house, and the lenders expected to be cushioned against the consequences of a high rate of defaults by those same rising prices: if they had to foreclose, the house would be worth enough more than the mortgage to enable the lender to recoup. A bubble arises not because people fail to perceive that an asset is overvalued, but because they think the perception is not widespread and therefore the asset will maintain or increase its market value. No one wants to sell an asset while its price is still rising, but if enough people think that way the price may rise to a point at which a slight perturbation in the market may cause a crash. Given the riskiness of subprime mortgage loans, a modest decline in housing prices or rise in interest rates (many subprime mortgages were at floating rather than fixed rates) could precipitate enough unexpected defaults to create distress not only among subprime borrowers but also among the lenders. Apparently that is what has happened.
Although the result is not a happy one, I do not perceive adequate grounds for government intervention. Proposals for limiting subprime loans have the quality of closing the barn door after the horses have escaped. The subprime "crash" has presumably educated both borrowers and lenders in the riskiness of the market, and if subprime lending persists it will not be because of ignorance of the risk. Of course if subprime lenders have resorted or are resorting to fraud in inducing such loans, they should be punished, but for that no new laws are required.

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Tracked on 06/03/2010 at 03:42 PM

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"A person may have a poor credit record, yet know that he can pay a high interest rate and that he will be better off despite the cost."

Or, a person may have a poor credit record, and yet still need a place to sleep and shelter her family.

I am sure that neither Becker nor Posner have ever lived with poor credit, so I would not expect them to appreciate the lack of options such people can have. (Whether they understand their legal situation or not.) I am not suprised then to see subprime mortgages characterized on this blog as a freely-bargained mutually-beneficial transaction. It still makes me laugh though.

Low income people are not "willing" to pay 20% or higher interest, they "must" pay. There are many areas of commerce where the freedom of contract model closely approximates real life transactions. Subprime mortgages are NOT one of them.

I have had the opportunity to read some of these mortgages... 15% rate hikes after the introductory periods, universal acceleration clauses on even a single defaulted payment. NO ONE would agree to this stuff if they understood its effect. They have practically the same chance of banking equity in a subprime mortgage as they would in a lease... zero. So it is mere propaganda to talk about all the "homeowners" created by this practice.

The practical result for the majority of these loans has been a lease by another name (with much harsher default consequences.) In fact in some areas (South Central LA being one), ballooning home equity loans have become a tool for ousting long time homeowners so that unscrupulous slum-lords can buy at the foreclosure sale, rent it back to the now tenant, and leverage the equity for themselves. (Ask any of the public interest law firms in a major city how many of these cases they've seen.)

Back in the days of Nader's fight with the auto industry, juries awarded multimillion dollar verdicts after discovering how managers pre-calculated the cost of wrongful death suits when deciding whether to add the extra safety bar. People will be just as angry when they discover that the whole risk model justifying subprime loans depended on a certain amount of "equity capture" during foreclosure sales.

"As Becker notes, although the rate of default on subprime mortgage loans is high, still, the vast majority of those loans are repaid."

Umm.. the main boom in subprime loans was within the last decade and most of these loans have 30 or 50 or more year terms. If they've been paid off already then the most likely story is the original borrower couldn't keep up and sold out of the house without actually defaulting. In that case obviously the goal of working class home ownership was not achieved.

It might be more accurate to say, the majority of these loans are still being repaid. Which of course says little about how much home ownership has actually been achieved (vs. interest paid) or how hard borrowers are struggling to avoid default. I think that is kind of a key distinction given how much of the justification for subprime lending turns on "it is the only way some people can own a home."

"As Becker notes, although the rate of default on subprime mortgage loans is high, still, the vast majority of those loans are repaid."

Umm.. the main boom in subprime loans was within the last decade and most of these loans have 30 or 50 or more year terms. If they've been paid off already then the most likely story is the original borrower anticipated being unable to keep up and sold out of the house without actually defaulting. In that case obviously the goal of working class home ownership was not achieved.

It might be more accurate to say, "the majority of these loans are still being repaid." Which of course says little about how much home ownership has actually been achieved (vs. interest paid) or how hard borrowers are struggling to avoid default. I think that is kind of a key distinction given how much of the justification for subprime lending turns on "it is the only way some people can own a home."

Situations are so various that regulating predatory lending through general rules is a failure in practice. That is, the rules tend to either be easy to get around, or to be so complex that entities which are not in the business of lending money are subjected to many traps for the unwary.

I've always been attracted to the simplicity and self-regulating character of a system which includes a very generous bankruptcy law, preserving the rights of secured creditors in their security but making it impossible to enforceably pledge one's earnings going forward. Of course there's not much room for rent seeking in such a system, so perhaps it is not politically feasible. Too bad.

The "sub-prime" lending "mess", is just another example of the problems created by the deregulation mania of the "supply-siders" in government and commerce since the early eighties. In this case, deregulation has led to the creation of new financial instruments (among other things) targeted at markets that were out of the normal-old regulated financial markets that created a stability in these markets. So is it any surprise that the stability has gone out of the market and "booms and busts" in various markets have taken its place? From a macroeconomic standpoint, the question becomes, is a stable market better than an unstable one?

I agree that fraud must be policed. And I also agree that borrowers should be informed. This second point, though, is easier said than done. Educated borrowers with excellent credit histories seldom understand all the material legal terms of their loans. Many folks with poor credit histories are either uneducated, not very bright, or not very honorable. It is exceedingly difficult to sort out the comparative impact of these variables. I agree with Posner that regulation may do more harm than good, but it is worthwhile if limited to combating fraud and fostering education. Forcing lenders to offer more generous terms, though, will do nothing more than dry up credit for people who may need it. In a free society we should be reluctant to impair an informed person's access to capital simply because his profile resembles those for whom accepting credit would be a poor choice. In the end a nanny state will operate to retard the maturation process.

The essence of the social compact resides in the protection of the ignorant and uninformed, as opposed to the informed. If all were informed equally, there would be no need of a "nanny state" and anarcho-capitalism could be allowed to reign supreme.

I agree with Posner's overall point re. the lifting of regulation of interest rates. However, it seems to me the interest rate is not the main problem causing high rates of default on these new types of loans. I see three other issues that need to be addressed by regulation.

First is that the new types of loans are complicated, often to the point that borrowers can't understand them. "Truth in lending act" disclosures are a partial remedy for this, but could be improved. It is also partly a fault of our school system, in which many people now graduate from high school (especially in low income areas) without the mathematical literacy to understand the terms of one of these loans. Perhaps borrowers ought to be required to demonstrate that literacy before they can be bound by the loan.

The second problem is the "time bomb" provisions built into many loans, in which the loan either ends with a "balloon payment" and must be refinanced in just a few years, or the interest rate goes up (or becomes adjustable in a way that will cause it to go up) after an introductory period. (Sometimes the "time bomb" arises because the payments are deliberately set too low, as in "interest only loans" and "negative amortization loans".) In these cases the borrower is gambling that he'll be able to refinance before the "time bomb" goes off, at rates he'll then be able to afford. It doesn't take much in the way of either a recession or a reversal of personal fortune for refinancing to become impossible or unaffordable when the time comes; in many cases it is impossible from the get-go and the lender knows it perfectly well from the borrower's credit score. It seems to me that, at least in that latter case, loans with any of these "time bomb" provisions amount to fraud and ought to be banned.

The third problem is contract provisions that are just out-and-out unfair; for example, a provision allowing the lender to raise the interest rate to a punitive level if the borrower is late on a payment to a different creditor, or if his credit score is reduced for any reason by a credit bureau. Practices like that simply need to be banned on general moral principles. If a lender feels it must charge more to risky borrowers, the rightful time to make that assessment and impose that rate is before the loan begins, not partway through it.

"If all were informed equally, there would be no need of a "nanny state" and anarcho-capitalism could be allowed to reign supreme."

No way. Plenty of people freely make foolish or self-indugent decisions even when sufficuently informed. Case in point: the hundreds of thousands of American families who have the means to save for retirement, but choose instead to purchase consumables. They are not ignorant. Even squirrels save for winter.

That said, while I'm not enamored with social contract theory I do agree that it is a fitting purpose of society to protect the weak. The prudential question is how best to do so. Too little protection leads to unnecessary suffering, but too much protection incents irresponsible behavior. Finding the right balance is tricky, and hoping for perfection is futile.

Interesting commentary. Judge Posner, in my view, is correct when he say that he "do[es] not perceive adequate grounds for government intervention."

One commenter speculates that "the main boom in subprime loans was within the last decade." This is preposterous. Over 25 years ago, I worked for a fairly large company that fixed up houses and sold them to people who wanted to own their housing, rather than rent it, even at interest rates and other onerous terms far worse than subprime lenders can extract today. (At the time, I was a dumb ol' carpenter responsible for fixing up defects in the properties, and quite envious of the customers who were buying homes while I was still a renter.) The commenter obviously is too young to remember the 24% mortgage lending rates of the early 1980s.

We don't need more loan regulations. We just need people to act a bit more maturely and not spend everything they make on beer and cigarettes (I'm using this as a catch all, you don't have to take me literally).

It's got nothing to do with income levels or even academic education and everything to do with character and discipline. Everyone should know that there is nothing free in this world and everything you borrow today must be paid back tomorrow. Immigrants are known for low wages AND saving money, so it IS clearly possible. On the other hand, I've seen well paid professionals spend everything they have with screwed up credit ratings because they don't know how to handle money.

John David Galt has some fair points. However, as a corporate attorney, I have seen some very sophisticated borrowers agree to those terms in financing commercial assets--and personally guaranteeing the debt.

To me, the abuse is the use of interest only, balloon ARMs, quite common here in Atlanta. That combination can be deadly, if the lender (or more accurately, the originator) knew that the buyer was "maxed out" on his monthly payments when the loan was still at the introductory rate.

But, what the hey, the borrower has been able to live in a very nice home instead of an apartment for some period of time, and can always bankrupt if it doesn't work out. The lender, OTOH, may be stuck with a home worth less than the amount he loaned on it. That is incentive enough to lenders to avoid this the next time around.

Thank you for Medeival Christianity view of interest...thinking of subprime mortgage lending, maximum transaction value...addicitions, prostitution, marijuana legalization, abortion...the more I read you guys the more I can see why free market economics could make sense....if a person wants to live like Anna Nicole Smith let them...when they no longer want to live that way there will be businesses (treatment centers) to help them not live that way (this works unless children are involved and they cannot call the 'take care of children center' to get away from their addicted, abusive parents)...all without government interference...just like subprime lending, if fraud is in play, there are laws to take care of that....this blog also brings to mind Arthur Anderson, Worldcom, Enron, City of Orange County California....what about the huge salaries of corproate bosses...those salaries could be taking away incomes from the little subprime borrower...dubious social benefit from home ownership...and what about sustainable living/global warming and huge houses being foreclosed upon...ah, income to the wrecking companies to go in and demolish and construct 20 story high rises...

Thank you for the Medieval Christianity view of interest...thinking about free market transactions and subprime lending...where people buy what makes them happy be it mortgages, alcohol, tobacco, or potentially legalized marijuana, the more I read you guys the more I can see where free market economics could make sense...if Anna Nicole Smith wanted to buy drugs and alcohol let her...if she wanted to stop she could buy a treatment center stay...(this works unless children are involved and then they cannot call the 'take care of children center' to get away from their addicted, abusive parents)...this brings to mind Enron, Worldcom, Arthur Anderson, City of Orange County California....the dubious social benefit of home ownership? I suppose when all the huge houses foreclose wrecking companies can go in earning income to demolish... new developers will generate value constructing high rises which could be in conformance with sustainable living principles...

You are all so worried about paternalism. We have a faulty defective product here! Subprime loans default at least 10% of the time. One in ten who borrows loses the home, often after substantial investment of cash. That is unacceptably high.

If I sold you an oven that burned down one in ten houses. You wouldn't be agonizing over personal responsibility and the proper scope of government largess, you would be suing me in products liability for all I was worth, and you would win. Why? Because it is settled that selling products with latent defects is unfair.

So what is selling a loan with a 10% default/foreclosure/eviction rate? Unfair. Unsafe at any interest rate. As a financial product, it should go the way of the Corvair. Void against public policy.

Subprime loans have a facially unacceptable risk of economic harm to one or both parties. (And these harms DO get externalized via public welfare, bankruptcy, tax-funded bank bailouts.) So who cares if the borrower is or isn't ignorant, look at the design of the instrument itself.

"One in ten who borrows loses the home, often after substantial investment of cash. That is unacceptably high."I don't see this as unacceptably high. I can say that I "own" a home... but I won't actually mean it until the mortgage is paid off. There is nothing wrong with renting and it actually makes more sense than borrowing in a lot of situations.

Nelson, Renting is a good approach to providing housing for those who can't afford home ownership. The problem is, there is an alarming decrease in rental properties available. The reason, property owners who are "flipping" the properties and converting them to condos. So what's an economically marginalised individual too do? They have no choice but to take out a sub-prime mortgage if they want housing at all. As the President has said, "Hey! Homeownership is up! Must be a sign that things are good."

Though Becker and Posner's arguments seem cogent, they're susceptible to a few flaws I'd like to point out.

The first flaw relates to the straightforward questions of consequence: ("Is a benefit created?" "Does this benefit outweigh any harm?") The second relates to proper distinction of entities.

I'd invite those who are interested to read (or reread) the Wall Street Journal article from May 30, 2007 "Subprime Aftermath: Losing the Family Home". http://online.wsj.com/article/SB118047548069017647.html?mod=most_viewed_week

The article is a study of a particular area and particular harms. And they are acute harms. But significantly, the article raises a more general possibility, saying "If events unfold as some predict, subprime lending could end up eliminating more homeowners than it created."

This is speculative, of course, but it is, after all, the fundamental piece of the benefit/harm calculation, and the jury's still out. If we look at a graphs of upcoming ARM resets or loans 60 days past due, we may conclude that the 2.4% default rate Becker mentions may not be the final word.

Leaving this doom-and-gloom possibility aside, we should consider a range of other evidence when measuring potential harm: the possibility of a Bear Stearns-size failure, the impact on the economy as a whole, etc.

Suffice to say I wouldn't play down the harms as Becker and Posner have.

Second, Posner says "The subprime 'crash' has presumably educated both borrowers and lenders in the riskiness of the market..".

Again, I'd make reference to this article. These "borrowers" and "lenders" are very different entities. The market is not comprised of billiard balls in a Newtonian universe; it is comprised, in this case, of individuals, brokers, marketers, bankers, mid-sized companies, and large corporations with tremendous resources.

Individual consumers are not comparable to large corporations with tremendous resources. So, the education of borrowers is very different from the education of lenders.

Though it may not be easy to quantify, a lasting analysis should seek to reflect this reality. Right now it is stark: when you're Bear Stearns, you're bailed out, and your "education" has a soft landing. When you're April Williams, you're 47, and you may lose your largest asset and never recover it.

From the macro perspective, it is unlikely that April Williams will contribute to the "wisdom" of the market in the near future. Nor will most other subprime borrowers.

It is from this point that we should begin to ask "Might some kind of intervention keep the benefits of the market, but reduce these harms and level the playing field?" And "Even if these horses are out of the barn, will there be other horses it'd be nice to keep fenced in?"

These are sensible questions. They're not scary. And they may look more sensible in the near future.

Most, but not all, of the comments above make me wonder why Dr. Becker, a Nobel laureate, and Judge Posner, one of the most erudite federal jurists we have ever been blessed with, maintain this blog. At this stage in their careers, it must be for entertainment value.

"The problem is, there is an alarming decrease in rental properties available."A self correcting problem. The quantity of houses is rising. If less people own their homes, there will be more available for rental units. Plus if investors can't make money from appreciation, they will try to make it through rental income.